IA2: ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF GOVERNEMENT ASSISTANCE, BORROWING COSTS, RELATED PARTY DISCLOSURES AND FINANCIAL REPORTING IN HYPER INFLATIONARY ECONOMY

This unit, is about International Accounting Standard 20: Accounting for Government Grants and Disclosure of Government Assistance, International Accounting Standard 23: Borrowing Costs, International Accounting Standard 24: Related Party Disclosures, and International Accounting Standard 29:Financial Reporting in Hyper Inflationary Economy.

ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF GOVERNEMENT ASSISTANCE, BORROWING COSTS, RELATED PARTY DISCLOSURES AND FINANCIAL REPORTING IN HYPER INFLATIONARY ECONOMY

STATEMENT OF ACCOUNTING STANDARD 20: ACCOUNTING FOR GOVERNMENT GRANTS AND DISCLOSURE OF GOVERNMENT ASSISTANCE

IAS 20, prescribes the accounting treatment of government grants and other forms of government assistance.

Accounting treatment

(a) A government grant should be recognized only when there is reasonable assurance that:

(i) the enterprise will comply with the conditions attached to the grant; and

(ii) the grant will be received.

(b) A grant in the form of non-monetary assets, such as, motor vehicle or other assets, may be valued at fair value or nominal value.

(c) Government grant should not be credited directly to equity: rather, it should be recognized  as income, on a systematic basis, over the period necessary to match it with the related cost, that is, the cost it is intended to compensate.

(d) Grants relating to income may be presented in the income statement either separately as  “other income” or deducted from the related expense.

(e) Grants relating to assets may be presented in the balance sheet either as deferred income or  deducted in arriving at the carrying amount of the asset.

Disclosures

(i) Accounting policy adopted for government grants.

(ii) Nature and extent of grants recognised in the financial statements.

(iii) Unfulfilled conditions attached to recognised government grants.

ILLUSTRATION 19

Antsa Farms Ltd, received a grant of N300,000, from Benue State government on 1st January 20X6, to assist the company procure an agricultural equipment which cost N400,000. The useful life of the equipment is estimated at three years after which it will be sold as scrap for N25,600.

(a) Show the amount of grant to be recognised in the income statement if Antsa depreciates equipment using the straight line method and the reduction balance method.

(b) Show how the grant will be presented in the financial statements if the company adopts the straight line method of depreciation and

(i) deducts the grant from the cost of the asset, or

(ii) treats the grant as deferred income. Assume that the company’s profit before depreciation of the equipment is N800,000, per annum.

SUGGESTED SOLUTION

(a) The depreciable amount of the equipment is N(400,000 – 25,600) N374,400.

(i) Straight Line Method

Amount of grant to be recognized if depreciation is calculated using the straight line method.

Year Depreciation Grant Income

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Tutorial

Recall the formula for calculating depreciation rate under reducing balance method. You will be able to determine that the appropriate rate of depreciation is 60%. In the third year, the grant income that will be recognized is the balance of the grant amount in the year.

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INTERNATIONAL ACCOUNTING STANDARD 23: BORROWING COSTS

Definitions

Qualifying asset is an asset that necessarily takes substantial period of time to get it ready for its intended use. Examples are property, plant, equipment and investing property.

Accounting treatment

(a) Borrowing costs that are directly attributable to the acquisition, construction or production of a qualifying asset must be capitalized as part of the cost of the asset. Other borrowing costs should be expensed.

(b) Where funds are borrowed for specific qualifying assets, the amount of borrowing costs eligible for capitalization, are the actual costs incurred less any income earned on the temporary investment of such borrowings.

(c) Where funds are borrowed generally, but are applied in part of obtaining a qualifying asset, the eligible amount for capitalization is determined by applying a “capitalization rate” to the expenditure on the asset. The capitalization rate is the weighted average of the borrowing costs applicable to the borrowings of the entity that are outstanding during the period, other than borrowings made for specific asset. The amount of the borrowing costs that an entity capitalizes during the period shall not exceed the amount of borrowing cost it incurred during that period (IAS 23.14).

(d) An entity should commence capitalization when expenditure for the asset is being incurred, borrowing costs are being incurred and activities necessary to prepare the asset for its intended use are being undertaken.

(e) An entity should suspend capitalization during the periods in which it suspends active development of a qualifying asset.

(f) Capitalization of borrowing cost should cease when substantially all the activities necessary to prepare the qualifying asset for its intended use or sale are complete.

(g) When the construction of a qualifying asset is completed in parts and each part can be used while construction continues on other parts, capitalization should cease when the entity completes substantially all the activities necessary to prepare that part for its intended use or sale.

Disclosure

An entity should disclose the amount of borrowing cost capitalized during the period and the capitalization rate used.

SELF ASSESSMENT EXERCISE

What is a borrowing cost?

INTERNATIONAL ACCOUNTING STANDARD 24: RELATED PARTY DISCLOSURES

Definition of related party (IAS 24.9). A party is related to an entity if:

(a) Directly, or indirectly, though one or more intermediaries, the party;

(i) controls, is controlled by, or is under common control with, the entity (this includes parents, subsidiaries and fellow subsidiaries);

(ii) has an interest in the entity that gives it significant influence over the entity; or

(iii) has point control over the entity;

(b) The party is an associate (as defined by IAS 28 Investment in Associates) of the entity;

(c) The party is a joint venture in which the entity is a venture (see IAS 31 Interest in Joint

Ventures);

(d) The party is a member of the key management personnel of the entity or its parent;

(e) The party is a close member of the family of any individual referred to in (a) or (b);

(f) The party is an entity that is controlled, partly controlled or significantly influenced by, or for which significant voting power in such entity resides with, directly or indirectly, any individual referred to in (d) or (e); or

(g) The party is a post-employment benefit plan for the benefit of the employees of the entity, or of any entity that is a related party of the entity

Related party transaction (IAS 24.9)

A related party transaction is a transfer of resources, services or obligations between related parties, regardless of whether a price is charged.

Close members of the family of an individual are those who may be expected to influence or be influenced by that individual in their dealings with the entity. They may include the individuals’ children, domestic partner and dependants.

Disclosure of relationship between parents and subsidiaries

An entity must disclose the name of its parent and, if different, the ultimate controlling party, irrespective of whether there has been transactions between a parent and a subsidiary.

Disclosure of management compensation

IAS 24 requires an entity to disclose key management personnel compensation in total and for each of the following categories:

  1. Short-term employee benefits;
  2. Post-employment benefits;
  3. Other long-term benefits;
  4. Termination benefits; and
  5. Share-based payment

Disclosure of related party transactions

If there have been transactions between related parties, an entity is required by IAS 24, to disclose the nature of the related party relationship as well as information about the transactions and outstanding balances necessary for an understanding of the potential effect of the relationship on the financial statements. At a minimum, the entity should disclose:

(a) The amount of the transactions;

(b) The amount of outstanding balances and their terms and conditions as well as details of any guarantees given or received;

(c) Provisions for doubtful debts related to the amount outstanding; and

(d) The expense recognised during the period in respect of bad or doubtful debts due from related parties.

The disclosures shall be made separately for parents, subsidiaries, associates, joint ventures, key management personnel and other related parties.

Examples of the transactions to be disclosed

The following are examples of transactions that should be disclosed if they are with a related party;

  1. Purchases or sales of goods;
  2. Purchases or sales of property and other assets
  3. Rendering or receiving of services;
  4. Leases;
  5. Transfers or research and development;
  6. Transfers under finance arrangements;
  7. Provision of guarantees or collateral; and
  8. Settlement of liabilities on behalf of the entity or by the entity on behalf of another party.

SELF ASSESSMENT EXERCISE

How do you determine if a party is related to an entity?

 INTERNATIONAL ACCOUNTING STANDARD 29: FINANCIAL REPORTING IN HYPER INFLATIONARY ECONOMIES

Hyperinflation

IAS 29 does not establish an absolute rate at which hyperinflation is deemed to arise but it identifies the following characteristics of such an economy.

(a) The general population prefers to keep its wealth in non-monetary assets or in relatively  stable foreign currency. Amount of local currency held are immediately re-invested to maintain purchasing power.

(b) The general population regards monetary amounts not in terms of the local currency but in  terms of a relatively stable foreign currency. Prices may be quoted in that currency.

(c) Sales and purchases on credit take place at loss of purchasing power during the credit period, even if the period is short.

(d) Interest rates, wages and prices are linked to a price index.

(e) The cumulative inflation rate over three years is approaching, or exceeds, 100%.

Further explanation of the 100% cumulative inflation rate

Under IAS 29, one of the characteristic of a hyperinflationary economy,  is that the rate of inflation over three years is approaching, or exceeds 100%. With compounding, this rates translates to an average of 26.7% for three consecutive years. This example illustrates how to determine when to classify an economy as hyperinflationary, based on the 100% three-year inflation rate.

ILLUSTRATION

The inflation rate in country X, as indicated by the general price index, has moved as follows over the past ten years:

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You are required to indicate the years in which a country should apply inflation accounting, based on the requirements of IAS 29.

SUGGESTED SOLUTION

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Based on IAS 29, inflation adjustments should be made in years 4, 5, 9 and 10 because, in those years, the increase in inflation for three years in a row was 100% or above.

The same conclusion is reached if calculation is done on the annual rate of change and selection of the years when the average rate for three years is greater or approximately equal to 26.7%.

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Rate of change for year 2 is calculated as follows (1,800 1,200)/1,200 = 50%

Average change for three years in year 4 is calculated as follows; (50 + 20 + 10)/3 = 26.7%

Restatement of financial statements

The financial statements of an entity whose functional currency is the currency of a hyperinflationary economy, should be stated in terms of the measuring unit current at the balance sheet date, irrespective of whether those statements are based on historical cost approach or current cost approach. Comparative figures for the previous period should also be restated in terms of the measuring unit current at the balance sheet date.

Gain or loss on net monetary position

The gain or loss on net monetary position should be included in profit or loss and separately disclosed.

Restatement of items in the statement of financial position

IAS 29, provides detailed procedures that should guide the restatement of items in the statement of financial position. The procedures are summarized below:

(a) Restatements are made by applying a general price index

(b) Monetary items are not restated because they are already expressed in terms of the monetary unit current at the end of the reporting period.

(c) Assets and liabilities linked to agreement on changes in prizes, such as index linked loans, are adjusted accordingly.

(d) Non-monetary items carried at amounts current, net realizable value and fair value, are not restated. All other non-monetary assets and liabilities are restated.

(e) A non-monetary asset carried at cost less depreciation is restated by applying the change in general price index from the date of its acquisition to the balance sheet date.

(f) A non-monetary asset carried at amount current at dates other than that of its acquisition, for example, property, plant and equipment that has been revalued at some earlier date, is restated from the date of its revaluation.

(g) The restated amount of non-monetary item is reduced, in accordance with appropriate IFRSs, when it exceeds its recoverable amount.

(h) At the beginning of the first period of application of IAS 29, the components of owners’ equity, except retained earnings and any revaluation surplus, are restated by applying a general price index from the dates that the components were contributed or otherwise arose. Any revaluation surplus that arose in previous periods is eliminated.

Historical statement of comprehensive income

IAS 29, requires items of income and expenses to be restated by applying the change in the general price index from the dates when they were initially recorded in the financial statements.

Current cost statement of comprehensive income

All income and expenses should be restated into the measuring unit at the end of the reporting period by applying a general price index.

Disclosures

The following disclosures should be made:

(a) The fact that the financial statements and the corresponding figure for the previous periods have been restated for the changes in the general purchasing power of the functional currency.

(b) Whether the financial statements are based on a historical cost approach or a current cost approach.

(c) The identity and level of the price index at the end of the reporting period and the movement in the index during the current and the previous period.

ILLUSTRATION

Mr. Giwa Jikolo furnished his company’s latest financial statements prepared under the historical cost basis, to Mr. Field Grass, a friend residing in the United States of America to seek financial assistance from him. The assistance is to purchase machines and equipment to replace the old ones, at present in use.

Mr. Grass faxed back the accounts requesting that they should be more realistic by showing the present values adapted to price index, current purchasing power or current cost; noting that the value of money is not constant especially in Nigeria where the Naira fluctuates widely against major foreign currencies.

He insists that his bank requires the information to grant the loan which he has applied for on behalf of Jikolo and Son Ltd. Jikolo’s financial statements are:

JIKOLO AND SONS LIMITED

PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31ST DEC., 2008

 N’000N’000

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Required

(a) Redraft the financial statements, using the current purchasing power basis. The price index at the beginning of the year was 100 while the index at the yearend was 120. All revenue transactions during the year are stated at average index of 110.

(b) Against historical cost measurement, advise on the use of:

(i) price index

(ii) current purchasing power

(iiI) monetary unit

(c) Outline the major requirements, Jikolo and Sons Ltd, might provide to meet the conditions for obtaining the foreign loan.

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(b) Advice

(i) Price Index

This is the expression of the prices of a group of commodities or general price levels of goods and services at a point in time to their prices at a chosen base period. The use of price index to restate historical cost accounting items ensures that assets are not understated and profits are not overstated which is usually the case with historical cost accounting in periods of rising prices.

(ii) Current Purchasing Power

This involves accounting for the effect of general price changes. The owners of the business are shareholders who suffer from general inflation as the purchasing power of their investment in the business declines. Changes in general prices are thus used to record the effect by adjusting all figures shown in terms of money with the same purchasing power. The re-statement is done using a general price index which tends to overcome the problem associated with historical cost accounting in periods of inflation.

 (iii) Monetary Unit

This is the fixed nominal amount of money attributable to an item in the financial statements without considering the effect of inflation. Monetary unit is not an alternative basis for restating items in the historical accounts to reflect the effect of inflation.

SELF ASSESSMENT EXERCISE

What are the characteristics of a hyperinflation economy?

 CONCLUSION

Government grants are assistance by government in the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity. They exclude those forms of government assistance which cannot reasonably have a value placed upon them and transactions with government which cannot be distinguished from the normal trading transactions of the entity.

Exchange differences arising from foreign currency borrowings and considered as borrowing costs are those exchange differences which arise on the amount of principal of the foreign currency borrowings to the extent of the difference between interest on local currency borrowings and interest on foreign currency borrowings.

Related party – parties are considered to be related if at any time during the reporting period one party has the ability to control the other party or exercise significant influence over the other party in making financial and/or operating decisions. Related party transaction – a transfer of resources or obligations between related parties, regardless of whether or not a price is charged.

In a hyperinflationary economy, reporting of operating results and financial position in the local currency without restatement is not useful. Money loses purchasing power at such a rate that comparison of amounts from transactions and other events that have occurred at different times, even within the same accounting period, is misleading.

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